Alba Martín Medina

Ximena Vega Lorigados

Group 55

International Economics
Universidad Carlos III de Madrid
Problem Set 6 - The Heckscher-Ohlin Model (Part C)

This problem set explores income inequality and the impact of allowing labor and/or capital mobility
instead than having free trade in goods and services. When factor mobility is allowed, not very
surprisingly, factors move towards the country where returns arte higher. The analysis is
straightforward.

1. Consider two countries (Spain and Romania), two goods (textiles and cars), and two
factors of production (skilled and unskilled labour). Romania is relatively abundant in
unskilled labor, and textiles are relatively intensive in the use of unskilled labour. Both
countries use the same technologies.

a) In the case of Spain, which group will be in favour of free trade between the two
countries.
In Spain, the group of skilled workers (which is the relatively abundant group of workers in
the country) will be on the side of free trade since no market barriers will make them export a
greater quantity of the products they produce (i.e. cars) which will increase production and
hence incomes will go up. Spain will get more benefit from importing the unskilled workers’
production (i.e. textiles) from Romania, since the group of unskilled workers is the relatively
abundant one in Romania. Because of this, the group of unskilled workers in Spain are at a
disadvantage compared to the group of skilled workers.

b) What will happen to income distribution in Spain and Romania after free trade?
In Spain, the skilled population will increase their incomes as car exportations grow, while the
unskilled workers’ salaries will diminish since they are not the relatively abundant group. The
income gap between the two types of workers will be bigger and the situation will be worse
because of economic inequality.
On the other hand, in Romania, the unskilled workers’ salaries will increase since the
increment of exports of the product made by their relatively abundant good, which is textiles,
will incentivize the increase of production and as a result, the increase of salaries. Hence,
there will be less disparities in relation to salaries between skilled and unskilled workers in
Romania and the distribution will be better off than in Spain.

c) How does free trade affects the incentives of Spanish workers to acquire skills?
Since in Spain there is a relatively abundance of skilled workers — that earn higher wages
than the not relatively abundant group because of increasing production (possible through free
trade), there will be little incentives for population to remain unskilled and thus they will be
more incentivized to acquire skills that allow them to become part of the advantaged group of
workers.

d) Which group will be in favor of free migration rather than free trade?
Those in favor of free migration rather than free trade will be the unskilled workers group in
Spain. They will not benefit from free trade as it would be more profitable for Spain to import
their kind of production from Romania, consequently they will approve of free migration as
 Alba Martín Medina
Ximena Vega Lorigados
Group 55

this would allow them to be part of the relatively abundant group of workers in Romania,
earning that way more profits while remaining unskilled.

e) To allow labor mobility is a close substitute for free trade?

Yes, as we can see in the following graph:

In the case of this free trade pattern, Spain’s skilled workers export cars to Romania and
unskilled Romanian workers, export textiles to Spain.
If labour mobility were to happen, unskilled Spanish workers would immigrate to work on
textiles to Romania and opposite wise, skilled Romanian workers, would migrate to Spain to
produce cars, consequently the outcome would of this action would be a close enough
substitute of free trade.

2. On January 1, 1994 the North American Free Trade Agreement (NAFTA) came into
force. This agreement signed by the United States, Mexico and Canada formed a free
trade area for goods and services that comprised the three countries.

a) Many unskilled workers of the United States and Canada strongly opposed this treaty
from the beginning of the negotiations in 1990. Using the Heckscher-Ohlin model discuss
which may be the causes underlying their position.
With this model we focus on differences in factor endowments between Canada, the US and
Mexico. One of the causes underlying unskilled workers’ opposition in Canada and the US
could be wage equalization. Basically, unskilled workers in Canada and the US have long
enjoyed a relatively higher income in comparison to the same group of workers in Mexico.
Knowing that all three countries have a relatively large supply of unskilled workers, there was
concern that greater competition from Mexican workers might push wages down in the US
and Canada, resulting in a possible decrease in living standards of unskilled workers. Also,
there is also more room for income inequality between the different groups of workers in the
US and Canada since NAFTA could exacerbate the wage gap if the gains from trade
disproportionately benefited skilled workers rather than unskilled workers.

b) After 25 years most economic analyses indicate that NAFTA has been beneficial to the
North American economies and the average citizen. Nevertheless, many Mexican
 Alba Martín Medina
Ximena Vega Lorigados
Group 55

workers still try to move to the United States. Does this go against any of the conclusions
of the Heckscher-Ohlin model? (Hint 1: In order to have Factor Price Equalisation, a
crucial assumption is that both countries have the same technology, Do USA and Mexico
have the same technology? Hint 2: If factor mobility is allowed, factors will move to the
country with the highest return.)
What the Heckscher Ohlin model states is that when two countries become trade partners, a
factor prize equalization will occur, but in order to accomplish what this model says, certain
factors such as technological parity need to be standardized within both economies.
Starting off by analyzing the first hint given, we would say the technological development of
Mexico is clearly in disadvantage with the one in the United States. Factor Price Equalisation
needs to meet the same level of technology in both states in order to occur.
Moreover, moving into the second hint, factor mobility will provoke the workers of the non
better off country (in this case Mexico), to move and work in the better off economy (USA) as
the salaries will be higher.
In conclusion, we do not believe this goes against the H-O’s model assumptions, we would
rather say the model cannot be applied to this specific case.

c) Some interest groups actively support the extension of the NAFTA to include the free
movement of capital. On the other hand, some other groups support the creation of a
complementary agreement that allows the free movement of labor in North America.
Using the Heckscher-Ohlin model discuss whether these propositions may make sense.
(Hint: Notice again that if factor mobility is allowed, factors will move to the country
with the highest return)
The free flow of capital would tend to equalize the returns on capital throughout the region,
according to the H-O model. However, as it may benefit capital owners while failing to
address issues with unskilled labor, this freedom of capital movement may also have
distributional effects, leading to a rise in income inequality. But granting freedom of
movement would suggest that employees might move freely to look for work in places with
the highest wages. The H-O model would result in salary equalization, which could help
unskilled employees in countries with higher wages in finding jobs that might pay better in
nations with lower wage levels, so lowering wage differences. However, given that there may
be a pressure on wages to decline as a result of the increase in labor supply, this may also
raise worries about potential job displacement in the nations where the workforce is moved
from.
Because of the aforementioned reasons we would need to keep in mind the following:
- Although it may not directly address labor-related issues, free capital flow can
increase overall efficiency and even exacerbate income disparity.
- Despite presenting difficulties in terms of job displacement and the distribution of
gains, free movement of workers can help equalize salaries.

3. Consider a world with two goods (steel and wine). There are two countries (Germany
and France) which have identical technologies and preferences. Assume that the
production of wine is relatively labour intensive while the production of steel is relatively
capital intensive. Assume that after free trade in goods, Germany exports steel and
France wine.
 Alba Martín Medina
Ximena Vega Lorigados
Group 55

a) i)What can you say about the relative endowments of the two countries?
We could say that as France has a relative abundance of labour and Germany has a relative
abundance of capital, France, will be then the one exporting wine, which is labour-intensive
and Germany, the one who exports steel, as it is capital-intensive.

ii)Which trade theorem are you using to answer this question?

The Heckscher-Ohlin model because it states that international trade is based on differences in
factor endowments between countries. Furthermore, it suggests that the countries export the
goods that are intensive in their relatively abundant factor, and import those that are not.

b) Before opening to trade in goods, both economies allow capital mobility.

i) Capital will flow in which directions (explain why) ?
We believe the capital will flow from the capital-abundant country, which in this case is
Germany, to the capital-scarce country, France as it would obtain higher returns.

ii) What will happen to the production of wine and steel in both countries?
As capital would flow from Germany to France, the production of the capital abundance good
(steel), would decrease in Germany. This outflow of German capital is likely to affect the
German wine industry, as the capital for investment in the production of wine, will be more
scarce. All those capital inflows to France could be put to use in the French steel industry,
increasing its production and generating higher profits. German capital inflows to France will
most likely make their wine industry to expand, leading to an overall increase of their
productivity.

iii) What will be the effect of capital mobility on factor prices in the two countries?
Given that part of the German capital will move to France, and as a consequence its steel
production will decrease even though the demand will remain the same, its price will increase
as the supply goes down. On the other hand, as we have seen in part ii), the French steel
industry will improve its productivity thanks German capital inflows, and as the supply of
steel will grow and the demand will still remain constant, prices will go down.
In France, investment on wine production increases which could be interpreted as an increase
in the enhancement of equipment (e.g. better machines), this could reduce unit costs while
increasing production meaning, greater benefits for wine firms that could be destined to
increasing workers’ salaries, yet when people’s wages go up, prices tend to increase as well in
proportion to living standards, so the price of wine will increase. Now, in Germany there is
less capital available for investment in the production of wine, so there could be 2 possible
outcomes: first, they remain producing the same supply but they decrease the quality of wine
as there are not the same economic resources as before and yet the price would stay the same.
 Alba Martín Medina
Ximena Vega Lorigados
Group 55

Second, wine supply decreases as they can’t invest as much in its production but want to keep
the same quality so prices would go up as there won’t be as much wine available as before
and demand remains constant.

c) Instead, assume that there is labor mobility instead of capital mobility.

i) In which direction will labor flow?

We believe that labor will move from the labor-abundant country, which in this case is France,
to the labor-scarce country, Germany.

ii) What will happen the production of steel and wine in both countries?
Knowing that many French workers would move to Germany we could say that there would
be an increase in labor in Germany, which could be destined to producing wine. The
production of steel is not intensive in labor and could remain the same in both countries.

iii) What will be the effect of labor mobility on factor prices in the two countries?
In terms of labor mobility, if there is a substantial relocation of labor into Germany, it may
result in a rise in the labor force there hence the availability of labor may grow, pushing down
salaries for both skilled and unskilled workers in Germany. Labor mobility in France may
result in worker emigration to Germany and this departure may cause labor shortages in
French industries, which may result in increased salaries or a tightening of the labor market in
some industries.

iv) The persistence of regional inequalities is much worse in Europe than in the U.S.
because of the lack of labour mobility. Discuss this statement in light of your previous
answers.
Labor mobility has historically been rather strong in the United States, with people migrating
between states to obtain employment. By enabling employees to take advantage of job
opportunities and meet labor shortages in booming regions, labor mobility can help eliminate
regional disparities. Compared to the US, there are clearly more restrictions on labor mobility
in Europe. Although the European Union authorizes the free movement of workers among its
members, social safety net inequalities, linguistic and cultural barriers, and variances in
occupational licensing continue to provide obstacles to labor mobility throughout the EU.
Another factor is how the economies of Europe and the United States are structured. There
may be more economic diversity and flexibility in some U.S. regions, which makes it simpler
for workers to find jobs across industries. Regions in Europe could be more specialized than
others, which might present problems for workers during downturns in local sectors.

4. When the EU-15 expanded towards the East of Europe, they decided to proceed in
two phases: First, they introduced free trade and then later the free movement of labour.
Using the HeckscherOhlin model discuss if it made sense to proceed in this manner.
In order to achieve factor price parity, the EU-15 initially engaged in free trade with nations in
Eastern Europe. Thus, when the EU-15 decided to implement free labor mobility, there
wouldn't be any migration for reasons of employment because wages would already have
converged between the regions, negating the need for migration in accordance with the H-O
model. As a result, the EU-15 and Eastern Europe would achieve convergence.